Hello, From the option price how can I compute how much the market expects the underlying to move over the next quarter, the next month, the next week, the next day... ? And if I think that the underlying will move less, how can I trade it? Thanks
There are 3 major accepted types that are to be considered which include: 1) historical volatility (how much activity has taken place in the past), 2) implied volatility (how much activity âthe crowdâ is assuming will take place in a determined forthcoming period of time) and 3) future volatility (how much activity actually takes place in the future in a determined forthcoming period of time.) IF A TRADER CAN STUDY #1 AND HOW IT RELATES TO #2, HE CAN PRESUME #3. IF A TRADER CAN CORRECTLY PRICE #3, THAT IS HOW HE BECOMES CONSISTENTLY PROFITABLE.
From a given 2) (implied vol) how can I compute the expected activity/range in $? Assuming the trader can price #3 better than the market, how does she exploit it? Can she exploit it on a daily basis?
IV is just the market's guess, first of all, and it may be right or it may be wrong. The future is kind of tough to predict. However, the formula for what the market is expecting is as follows: (Volatility level/100)/sqrt(365/No of days) Sqrt = Square root Or, for the denominator, ((365/No of days)^.5), which gives the same answer. (see Fractional Exponents here) So, given an IV of 37.15%, and an expiration for some option 70 days in the future, you do (37.15/100)/sqrt(365/70) = .16. This gives you the percent the market expects it to move over the period given. Thus, .16, or 16%, is the percent band you can expect it to move in for the next 70 days. All financial arithmetic assumes a normal distribution, by the way, and that's implicit in this formula. In the markets, normal is normal until it ain't. That's the fun part, or not, depending on if you get caught without an umbrella when the rain comes.
Thank you! What strike should I pick? ATM? And if your opinion is different from the market expectation, how do you trade it?
TOS gives the IV levels overall for each month on its trading page. Other brokers I'm sure do something similar. On indexes, you can use the associated volatility index as well as the IV's on the options: VIX for the SP 500, RVX for the Russell 2000, etc. The CBOE volatility site lists all the available volatility index symbols. As for how to trade a different expectation than the market, that's endless. It is, after all, how you make money if you're right, and there's no one answer to that. You're going to need to thoroughly explore all the different strategies there are out there. That CBOE site has a lot of good educational stuff on it. Paper trade before going live. You'd be amazed how quickly you can lose money if you haven't done your homework.